Helped by Coronavirus Food Assistance Program (CFAP) legislated for the Food Box Assistance program dairy purchases, Class III prices made an amazing recovery in June, rising from May’s bitterly low $12.14/ cwt to the $21.04/cwt announced by the Milk Market Administrator on July 1, 2020 (Figure 1). The possibility of additional cash flow at the farm level quickly evaporated as the specter of a record negative producer price differential (PPD) surfaced.
Unfortunately, the June final milk check revealed a record-high negative $7.05 PPD for Federal Order 33, reflecting brutal, unintended consequences of a Federal Milk Marketing Order rule change. A change in how Class I price is calculated went into effect in 2019, driven by organizations representing processors and cooperatives and included in the 2018 Farm Bill. Unfortunately, bad things happen when there is a large spread between Class III and Class IV prices and prices rise rapidly. And it just did.
Figure 1: Class III price, July 2019 through June 2020, $ per cwt.
Negative Producer Price Differential (PPD)
Our Federal Order 33 is a component-based system, as are 6 other of the 11 Federal Orders. Class I (fluid or bottled) milk is usually the highest value milk in this system and that price is set off of the Class III and IV prices which are usually lower (Figure 2). In this “normal” scenario, the price farmers receive for their milk is the Class III price plus a share of the higher value of Class I milk pooled in the Federal Order (represented by the PPD) if their cooperative or processor participates in the Federal Order system. So typically, the Class I price is higher than the Class III price, the PPD is positive, and this adds dollars to the milk check.
Figure 2: Class prices, FMMO 33, January through May 2020, $ per cwt.
Every dairy farmer knows that sometimes the PPD has “gone negative”, and in spite of efforts to tweak pricing rules, it still happens. Negative PPD surfaced most recently in 2019, with negative PPD from September through December ranging from ($0.31) in September to ($2.44/cwt) in November.
June’s Class III price announced at $21.04/cwt was a welcome and dramatic increase from May’s dismal $12.14/cwt. At the same time, the Class IV price only increased from $10.67 to 12.90/cwt (Figure 3). Class III and IV milk prices are used to calculate the Class I price. Before the rule change, Class I was calculated using the higher of Class III or IV prices. Now it is calculated using the average of Class III and Class IV prices plus 74 cents (the historical difference between the two prices). Because of the change, Class III milk has a higher value than the Class I price for June, resulting in a negative PPD.
Figure 3: Class prices, FMMO 33, January through June 2020, $ per cwt.
How low could it go?
Before the June PPD was announced on July 13th, what we did not know was how negative it would be. The unknown factor was how much Class III milk, normally pooled in the Federal order, would be depooled? The higher the amount of milk depooled, the higher the negative PPD would be. So, what does this mean? The federal order system is complicated with an extensive set of rules. Let’s take a simplified look at how it works:
Class I milk, or milk that goes into a jug for fluid consumption, has to be “pooled” on the Federal order. In other words, if a processor bottles milk, which is usually the highest value milk in our pricing system, they pay the difference in value between Class I and Class III into the Federal order pool each month. At the end of the month, an accounting is made of how many pounds of milk were pooled in the Federal order for the given month and how much was utilized as Class I, II, III, or IV (Figure 4). Based on dollars paid in and how many pounds were pooled, the PPD is announced. In theory, this shares the higher value of fluid milk with all participating farms, regardless of whether they have the opportunity to ship to a fluid milk processor, or their milk is going into cheese, butter, or some other manufactured product.
Figure 4: Milk utilization by class and total pounds of milk pooled in FMMO 33, January through May 2020.
While Class I processors have to participate in the Federal order system, Class III processors do not. They usually do because it allows them to pay more than the typically lower Class III price to their farmers in the form of the Class III price plus the producer price differential.
Class III worth more than Class I
However, when the Class III price is higher than the Class I price, the Class III processors are now in the position of having to pay into the Federal order. They can choose to pool fewer pounds of milk than they have normally pooled in the Federal order to minimize the dollars they would have to pay in. This is termed “depooling”. When this happens, there is not a pool of dollars reflecting the highest value of milk, and the PPD becomes negative, reflecting the value and use of the milk that was pooled on the Federal order.
In June, Class I milk was worth $13.42/cwt, while Class III hit $21.04/cwt. The final accounting was brutal for dairy farmers, with 429.5 million pounds less Class III milk pooled in June than the average Class III pounds pooled January through May in FMMO 33.This dropped Class III utilization from an average of 32% for the first 5 months to 9.8% in June (Figure 5).
Figure 5: Milk utilization by class and total pounds of milk pooled in FMMO 33, January through June 2020.
The FMMO 33 Class I price for July is above $18/cwt but will still likely be lower than the July Class III price. It is anticipated that we are in for several more months of negative PPD.
This is a very basic look at what happened. Two dairy market experts, Mark Stephenson, University of Wisconsin, and Andrew Novakovic, Cornell University, did an excellent job putting together a very readable paper “Making Sense of Your Milk Price in the Pandemic Economy: Negative PPD, Depooling, and Reblending”, which addresses additional issues not included here. This paper is worth reading and can be download from: https://dairymarkets.org/PubPod/Pubs/IL20-03.pdf